- FX markets driven by unwinding of USD longs; investor gloom and shifting Fed hike expectations
- Against this background safe haven currencies have performed well but this is unlikely to last
- Our constructive view on the global economy suggests commodity FX and the USD should recover
FX in the currents of three big forces
There have been three dominant drivers in currency markets since the start of this month. Investors have taken profit on extreme long US dollar positions, with the dollar’s move higher losing momentum. This was partly on a focus on less favourable news about the US economy in the process, such as the dovish comments of some Fed officials and rare disappointing US data. Weaker economic data have triggered concerns about the state of global economic outlook, while stronger numbers have been ignored. As a result, investor sentiment has deteriorated dramatically, leading to hysteria at some points. This was reflected by sharp drops in equity markets and bond yields (especially US Treasury yields). Meanwhile, equity volatility and gold prices rose. Last but not least, the sharp sell-off in cyclical commodity prices such as oil, base metals, palladium (to a lesser extent platinum) had an immediate negative impact on currencies of commodity exporters and influenced the expectations about monetary policy of central banks. For example, the recent weaker than expected eurozone data and the drop in oil prices have resulted in a rise in expectations of further monetary stimulus by the ECB.
Meanwhile, financial markets now expect a later start of the Fed hiking cycle. For example, markets have dramatically reduced expectations of Fed rate increases in 2015 (see graph). This reflects that there has been a lot of focus on the comments of more dovish Fed officials. We think that in general the FOMC has confidence in the US economic outlook and judges that inflation will gradually move up towards the central bank’s inflation objective. We could see more commentary from officials in this direction going forward.
Safe currencies have benefited
Currency markets have been buffeted around, because none of these forces was the most dominant. For a start, the US dollar has fallen under pressure because of profit taking, but also because of a downward adjustment in expectations about US growth and the likelihood of later Fed hikes. However, the euro also has fallen out of favour because of weaker eurozone data, and the fear of deflation and recession in the eurozone. These fears are overdone, in our view. The lower than expected inflation data in the UK have also resulted in investors pushing back their view of the likely timing of BoE rate hikes, which has hurt sterling. Moreover, currencies of oil exporters such as the Norwegian krone, Canadian dollar and Russian ruble were among the weakest. Meanwhile, safe haven currencies such as the Japanese yen and the Swiss franc profited from the deterioration in investor sentiment. In addition, the Australian dollar (AUD) and New Zealand dollar (NZD) benefited from market expectations that China has more room to implement targeted easing measures to stimulate its economy, as inflationary pressures have declined.
Stronger economic data will change the picture
We maintain the view that the pessimism is overdone. We think it is more likely that stronger economic data will lift the gloom and support an improvement in investor risk appetite going forward. Therefore, it is likely that safe haven currencies will come under pressure again in the coming weeks. Stronger economic data will probably result in a stabilisation and recovery of cyclical commodities such as oil, and base metals. Therefore currencies of these commodity exporters could also recover. More broadly, our view that the US economy will do well and that the Fed will eventually raise rates in 2015, suggests that the dollar will resume its uptrend.